Notes for Session 3
Econ 201
In this session we continue to discuss the incorporation of an important sector to our simple economy’s production: international trade. For the sake of continuity, we re-introduce international trade into our Model II (overlap with Notes for Session 2). A few important insights about the role of trade deficit (or trade surplus) emerge which are explained below. Introducing International Trade: What happens to our national income (NI), our national product (NP), and our aggregate expenditures (AE) when we trade with the rest of the world (ROW)? Take Model II with all its assumptions. Now, suppose we export 2 of our cars to ROW and purchase 3 cars from the ROW (each car is priced at $5000). That is, we import 3 cars and export two. Since we export 2 cars, that leaves us with 14 cars for domestic consumption. Also, since we import 3 cars, our total consumption is 14 +3 cars and its value is: 17 cars* $5000 = $85K Has out national product (NP) changed from Model II? No! We still produce 16 cars and 2 trucks so the value of our goods and services, our National Product is still $100K. Has our national income (NI) changed from Model II? No! We have 10 workers, 8 of them produce cars and the rest produce trucks. The Household Income from previous model is wages + dividends for a total of $80K plus the undistributed profits of firms which is firms’ income (or savings—firms do not consume) at $20K. So the total for income or NI = $100K What about our Aggregate Expenditures (AE)? The expenditures constitute C at $85K, I at $20K, and also Exports to other countries (X) at $10K, for a total of $115K!! Is this correct? What is amiss? Why are our AE so far not the same as NI or NP? The discrepancy is due to imports (M). Of the 17 cars consumed in this economy, 3 of them –each priced at $5K--are not produced here! Therefore, our aggregate expenditures on domestic goods and services, AE, is $115K - $15K= $100K. This is the same as our NP, and our NI. Therefore, when we have foreign trade, our AE is:
AE = C + I + (X-M) where (X-M) is called Net Exports. Where Net Exports are negative, that is, where our value of X is less than our value of M, we have a trade deficit! To establish how our aggregate savings is affected with the introduction of foreign trade, let us remember that being on the circular flow of production, income and expenditures, two forces, NI and AE are equal in value. Therefore, we know that National Income (NI) = Aggregate Expenditures (AE) NI = Income of HH (households) + UP AE = C + I + (X-M) Therefore, Income of HH + UP = C + I + (X-M) Subtract C from both sides: (Inc of HH – C)+ UP = I + (X-M) Subtract (X-M) from both sides (or add M-X to both sides) (Inc of HH – C) + UP + (M-X) = I (Inc of HH – C) = HH Savings UP = firms’ savings (M-X) = foreign savings! Indeed here, we have a trade deficit of $5K since our X is $10K and our M is $15K. Therefore, foreigners have a $5K balance which they can either keep in terms of cash dollars, or put in a $ denominated savings account, or purchase U.S. bonds and stock with. Therefore, our $5K trade deficit is in fact $5K of foreign savings provided for investment in the U.S.! In summary, our trade deficit is yet another source of savings –from abroad—that can be used for investment at home! Therefore, the equality: (Inc of HH – C) + UP + (M-X) = I Can be written as: HH savings + Firms’ savings + Foreign Savings = Investment Note a few important insights: 1. Reducing our trade deficit will change the other side of the equation, that is, if nothing else changes, a reduction in trade deficit means a reduction in our investment, which will negatively affect our long term growth prospects! 2. If we want our trade deficit to be lower and yet have no reduction in our level of Investment, we need to either have less C (more HH savings) or more firm savings.
3. Our trade deficit is a macroeconomic issue; it is not really about how expensive US goods are relative to other countries’ goods. It is also not explained by other countries’ trade barriers. It seems that people in other countries may find US goods competitive but prefer to purchase U.S. bond and stocks, our assets! How would you interpret the presence of positive net exports? If X>M, them MX is negative. That is, the level of foreign savings is negative. This means a net outflow of OUR savings to the other countries. It means that we, at home country, are investing in other countries! Note that it is impossible to have both a trade surplus and have a net inflow of foreign savings!! The identity will hold for every country, China, U.S., India, Japan, Mali, Paraguay, etc. Therefore, if any of these countries are having positive net exports (also called a trade surplus), they are providing their savings to the international community and their citizens are investing in other countries. Example: HH income and C in a country are $530 billon and $450 billion. The level of firms’ savings is $120 billion and the level of investment in this country is I = $100. Calculate the trade balance, explain if this country faces a trade deficit or surplus, and interpret your finding as provision of foreign savings or provision of the home country’s savings to the outside world. Use the following identity: (Inc of HH – C) + UP + (M-X) = I (530-450) + 120 + (M-X) = 100, M-X = -$100 billion. This means that X – M = +$100 billion. Therefore, this country runs a trade surplus of $100 billion, implying that the residents of this country are investing $100 billion in other countries in the world!
Adding Government to our Circular Flow Model We consider one more important sector: Government. Governments purchase goods and services (defense, education, highways, parks, etc.) and in order to pay for them, they tax the income of their citizens (and corporations). Your textbook presents a full treatment of the role of government in pages 16-23 (online version). You can read this part carefully to figure out how government’s decision to purchase good (trucks) affects the amount of goods and services available for consumption and firms’ investment. Of course, you will not be tested on the details of treatment of government as is done in the textbook. Here, we make use of the Saving and Investment identity on pages 21 and 22 to discuss the role of government deficit or surplus in our long term path of economic growth. Just as discussed in Chapter 2 in pages 16-23, note that the introduction of government does not change our aggregates: National Income, National Product, or Aggregate
Expenditures. We still have the same resources, workers who are working full time and producing goods and services. The introduction of government sector simply means that some of these workers will be working to produce “government goods” and so there needs to be either less C or less I, or less of both. When we add government sector, our National Income is now: Disposable Income of Households (Disposable Income = income after taxes) + UP (undistributed profits of firms, also after taxes) + Tax revenues. In short form: NI = DI + UP + T Our Aggregate Expenditures are now: AE = C + I + (X-M) + G Where G is the level of government expenditures on goods and services. Since AE = NI DI + UP + T = C + I + (X-M) + G (this equation is on page 74 of the textbook). Now, subtract C from both sides: (DI – C) + UP + T = I + (X-M) + G Subtract G from both sides: (DI – C) + UP + (T-G) = I + (X-M) Now, add M-X to both sides: (DI – C) + UP + (T-G) + (M-X) = I The above identity is interpreted as: HH savings + Firms’ savings + Government savings + Foreign savings = Investment. If government runs a “budget deficit”, it implies that the sign of Government savings is negative since T<G. Government budget deficits:
Twin deficits: the presence of both government budget deficit and trade deficit is called the “twin-deficits”. As government needs to finance its budget deficit, it would issue bonds or “IOUs” that would be offered to domestic and foreign residents. Specifically for foreign residents, the desirable interest rate offered by the U.S. government on its bonds may prompt people in other countries to buy these bonds (instead of buying U.S. goods, the foreign residents may prefer to buy U.S. government bonds) which is in effect, lending to the U.S. implying a trade deficit for the U.S. Therefore, large government budget deficit may lead to a widened trade deficit. Interpretation of the aggregate savings = Investment identity: It is important to know: we can’t change only one component! If we are interested in reducing or eliminating trade deficit we need to have: higher savings, less consumption, or higher taxes or major government spending cuts or reduced capital investment—this will hurt our long term economic growth prospects [Of course, all the assertions above assume a given value for the U.S. dollar against other currencies. If foreigners desire to both lend less and buy less goods and services from us, then the value of the U.S. dollar against other currencies will fall as it has fallen.] Example: An economy’s level of disposable (after tax) household income is $100 billion. The level of household consumption is $90 billion. Firms in this economy have undistributed (after tax) profit of $5 billion and their level of investment is $35 billion. Government tax revenues are $40 billion and its expenditures are $50 billion. What is the level of net exports in this economy? Does this economy face a trade deficit or trade surplus? Solution: (DI-C) + UP + (T-G) + (M-X) = I (100-90) + 5 + (40-50) + (M-X) = 35 M-X = $30 billion so that net exports are (X-M) = -$30 billion. Therefore, this economy faces a trade deficit of $30 billion. In this case, government runs $10 billion of deficit in its budget. The shortfall of $30 billion in trade balance is partly loaned to government ($10 billion of it) and partly loaned to businesses ($20 billion) to augment the savings of HHs at $10 billion and the firms’ own savings at $5 billion to a total of $35 billion that businesses invest. If the right hand side number for I is kept unchanged but government saves more (has a budget deficit less than $10 billion), then keeping C, DI, and UP constant, we
know that the trade deficit will be smaller. In this case, smaller government budget deficit has led to smaller trade deficit (twin deficits). Addendum Adding Government Tax and Spending to Model II (including international trade)—detailed numerical solution Congress decides to buy 4 trucks. cars•1/2 + business trucks + gov't trucks = 10 workers Produce fewer trucks for capital investment, or fewer cars for households, or both. Let's assume domestic car production falls by 6 and business trucks by 1. Our economy does import 3 cars and exports 2 cars, so domestic consumption of cars = 11 cars at $5000 each = $55K How will government pay for trucks? Congress imposes 10% tax on household income (only) Let’s calculate the National Product: Auto Firms' Product Sales 10 cars @ $5k: $50,000 value of product: $50,000
Truck Firms' Product Value of Goods Produced: Sales 5 trucks @ $10,000: $50,000 The National Product (NP) is the total value of goods produced: NP = $50,000 + $50,000 = $100,000
To calculate the National Income: Auto Firms' Profits Sales 10 cars @ $5,000:
$50,000
-Wages 5 workers@ $7k: 35,000 Profits (before dividends are paid) = $15,000 We assume this firm pays $5,000 in dividends and keeps the rest, UP = $10,000. [For questions in your quizzes and other tests, you will be given information on the proportion of profits the firm gives out as dividends]. Truck Firms' Profits Sales, 5 trucks @ $10,000: $50,000 - Wages, 5 workers @$7k: -35,000 = Profits (before dividends) $15,000 This firm gives all profits as dividends to HHs. Therefore its undistributed profits are $0. How does the income tax affect the financial situation of the households? It reduces the income left for consumption or savings.
Households' Income and Expenses Wages: 10 @ $7,000 $70,000 plus all Dividends $5,000+$15,000= $20,000 equals Personal Income $90,000 less Income Tax of 10% $9,000 equals Disposable Income: $81,000 - Consumption Spending (11 carsâ&#x20AC;&#x201D;3 are imported): $55,000 equals Personal Savings: $26,000 Government Tax revenues: $9,000 Government's Income and Expenses in Model IV equals Total Tax Revenue $9,000 less Government Spending -40,000 = Government Surplus -$31,000 A touch of reality: government may spend more than it collects in taxes! National Income by sector: Household Disposable Income + Government Tax Revenues + Firmâ&#x20AC;&#x2122;s Undistributed Profits National Income = $81,000 + $9,000 + $10,000 = $100,000, so National Income = National Product (calculated earlier) = $100 K
How about Aggregate Expenditures (AE)? Consumption $55,000 Investment $10,000 Gov't Purchases $40,000 X-M -$5000 AE = C + I + G + X-M = $100,000 We can see that NP = NI = AE Finally, is S = Investment? We can prove the S = I identity in general: Aggregate Expenditures = National Income: Consumption + Investment + Government purchases + (X-M) Equals Disposable Income + Undistributed Profit + Tax revenues In symbols: C + I + G + (X-M)= DI + UP + T rearrange as: (DI-C) + UP + (T-G) + (M-X) = I, In words: Household (Personal) Savings + Undistributed Profits (firms’ savings) + Government Savings + foreign savings = Investment The Savings and Investment Elements of our model are: Household Sav + Business Sav + Gov’t Sav + Foreign sav = Investment (DI-C) + UP + (T-G) + (M-X) = Investment ($81K-$55K) + $10K +(-$31K) + ($5K)=$10K Government is short $31,000 and borrows from other sectors with surplus (savings) How has the economy “made room” for government trucks? Lower household consumption, and Less investment in new capital goods Is society better off than before?
The concept of “twin deficits” in the 1980s (and also in 2003-2007 period where government is running large deficits again): Federal Gov had a large budget deficit. US Treasury had to offer higher rates. Rest-of-the-World (ROW) found our interest rates attractive, saved $ and lent them to U.S. Treasury. Savings by ROW is our trade “deficit”. ROW saving has (partially) financed our Government budget deficit.